A LIBOR of love: considerations for use of IBOR fall-backs or active transition
The Working Group on Sterling Risk-Free Reference Rates (the Sterling Working Group) is an influential body of the Bank of England formed for the purpose of coordinating an orderly market transition from GBP LIBOR to risk free rates such as SONIA, by the end of 2021. During April 2021, it has published papers to assist derivative market participants with this transition. (For further background on the recommended timing for LIBOR transition see our Eye on IBOR Transition blog post here.)
In the first paper, the Sterling Working Group considers the factors which may be relevant to firms when deciding whether to rely on contractual fallbacks to LIBOR such as the ISDA IBOR Fallbacks Supplement or the ISDA 2020 IBOR Fallback Protocol or to actively transition contracts from LIBOR to RFRs. The Sterling Working Group recommends identification of GBP LIBOR contracts expiring after the end of 2021 by the end of Q1-2021 and for transition of appropriate contracts by end-Q3 2021.
Whilst fall backs are a method to ensure contractual continuity in derivative contracts post LIBOR cessation, UK regulated firms are required by the UK regulators to consider whether active transition is more appropriate, and the Sterling Working Group recommends active transition ahead of LIBOR cessation as the primary method to ensure contractual certainty and retain economic value.
In that context, the Sterling Working Group has highlighted the following considerations as relevant to the decision whether to actively transition derivative contracts to RFRs:
- Consistency with existing RFR market conventions: ISDA’s IBOR fallbacks use a 2-day backward shift methodology which is not consistent with current OIS market conventions, and fallen-back trades are therefor not eligible for clearing.
- Resource requirements: ISDA fallbacks provide an efficient means of amending a large volume of contracts, whereas active transition requires more resource.
- Operational risk: reliance on fallbacks could lead to a ‘big bang’ with risk highly concentrated around the Cessation Effective Date of 31/12/21.
- Trading cost: there may be a trading cost associated with rebooking transitioned trades.
- Alignment with hedges: fallen-back trades may have different fallbacks to hedges.
- Liquidity: there may be potentially less liquidity in non-cleared fallen-back trades, whereas transitioned trades can be made to match cleared conventions.
The second paper highlights some key infrastructure and operational considerations for derivative market participants relating to the operationalisation of fallbacks in non-cleared linear (i.e. forwards and swaps as opposed to options) GBP LIBOR derivatives, including:
- Trade booking infrastructure: firms should assign ownership of the task of preparing for fallbacks and prepare an impact assessment by system and process to determine the work required for preparing for fallback adoption.
- Risk management infrastructure: firms should assess risk management systems and processes to determine the work required to support pricing, valuation and VaR modelling of fallback scenarios.
- Accounting infrastructure: firms should ensure accounting standards and systems appropriately reflect the new accounting standards relating to IBOR transition and fallback bookings are appropriate accounted for.
- Regulatory reporting: utilisation of a fallback would amount to a modification of a derivative contract which is reportable under EMIR. Firms should ensure UK EMIR reports are updated in a timely manner.
Please speak to your Mayer Brown contact if you require any assistance with preparing or relying on contractual fallbacks or are considering actively transitioning from LIBOR rates to RFRs in your derivative documentation.